In mid-2009, Rite Aid had CCC-rated, 88-year bonds outstanding with a yield to m

Question

In mid-2009, Rite Aid had CCC-rated, 88-year bonds outstanding with a yield to maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 4%. Suppose the market risk premium is 4% and you believe Rite Aid's bonds have a beta of 0.39. The expected loss rate of these bonds in the event of default is 54%.

a. What annual probability of default would be consistent with the yield to maturity of these bonds in mid-2009?

b. In mid-2015, Rite-Aid's bonds had a yield of 6.6%, while similar maturity Treasuries had a yield of 1.4%.

What probability of default would you estimate now?

Explanation / Answer

A)

Rd=4%+0.39(4%) = 5.56% =y - pL=17.3% -p(0.54)

p=(17.3%-5.56%)/0.54= 21.740 %

B) p=(6.6% - 1.4% -0.39(5%)/0.54=  6.74074 %

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